We will examine four market structures. This chapter looks at perfect competition. The next two chapter will look at what we generally call imperfect competition. Imperfect competition consists of monopoly, monopolistic competition, and Oligopoly.
What is pure competition?
What is Monopoly?
What is monopolistic competition?
What is Oligopoly?
Characteristics of Perfect Competition.
1. Many buyers and sellers.
2. Homogeneous (standardized) product. All the products of each firm is exactly the same.
3. Easy entry and exit, i.e while it is easy to enter it does not mean it is costless. The cost is just not so expensive that it prevents people from entering.
4. Firms are price takers.
What do we mean when we say a firm is a price taker? Why are they
What happens if the firm tries to raise its price above what everyone
Why doesn't the firm just lower its price to get more customers?
Demand for perfect competition.
Why can't the firm in perfect competition have a pricing strategy.
I.e. why must it accept the price determined by the market, why is it a
Why is the demand curve for one firm in a perfectly competitive market
perfectly elastic? Remember a perfectly elastic demand curve is horizontal.
It is very important to remember that, although the individual firms demand curve is horizontal, the market demand curve is downward sloping like we discussed all semester. Thus when all the firms are put together then the market demand curve will look like the negatively sloped demand curve we have grown to love. If the market wants more people to buy the good (exact same good that all the firms are producing) it must lower its price. But each firm being such a small part of the market has no influence on the price and thus accepts the market price and charges that price.
(Insert table 9-1 and figure 9-1 here)
Notice that the price of $131 that the individual firm (it is important
to remember we are talking about the individual firm ) is determined by
the market place. Thus, for this particular good, the market demand curve
(negatively sloped) and the market supply curve (positively sloped) intersect
each other and determine the equilibrium price which in this example is
Now go to table 9-1. Total revenue is equal to P * Q Thus if you draw
the picture on figure 9-1 you will see what TR is. Marginal revenue is
the change in TR divide by the change in price. Notice going from 2 unit
sold to three units sold, TR goes from $262 to $393. The change is $131
(the change in output is 1 (4-3) so MR = $131). Notice it will always be
$131 which is the price. So MR = P. This has to be because the extra revenue
you get from selling one more unit of output (MR) is the price that the
Put the picture of how the firms horizontal demand curve is derived
from the supply and demand curve in the market place.
Notice how the market establishes the price of P and the single firm
accepts that price. If the firm tries to charge a higher price then it
would loose all their customers because they would go elsewhere. No need
to charge a lower price because we see they can sell all they produce at
the market price so why charge less.
So a single firm in perfect competition:
The question we want to determine now is, how does the firm know how much output to produce in order for it to maximize profit? Remember
Profit = TR-TC
so when the difference between TR and TC is the greatest profit will
be maximized. On table 10-3 the greatest difference occurs when the firm
produces 9 units of output.
(Insert Table 9-2)
Profit is a maximum at $299 which occurs when the firm produces 9 units of output. This is the greatest distance between TR and TC.
If you plot TR and TC you will get the picture in Figure 9-2.
(Insert Figure 9-2)
You should be able to see that the vertical distance between TR and
TC is the greatest at 9 units of output. That vertical distance is profit
because TR-TC equals profit.
Another method to determine when profit is maximized is called the Marginal
Revenue (MR) Marginal Cost (MC) approach.
Essentially profit is maximized when MR = MC. Once we prove that this
is where profit is maximized, all we have to do is simply look at the point
where MR curve intersects the MC curve. At that point we see what the output
level is necessary to maximize profit.
We will now prove that profit is maximized when MR= MC.
It is very important to remember that when we say profit is maximized
it means that profit can't be increased any more. If for some reason we
show that profit may still rise then it is not at a maximum. This is often
a bit confusing because we all know that we would rather see profit rise.
And in fact the firm does want profit to rise (It is better to go up than
down) . However, profit maximization means it can no longer rise, it is
the highest it can be, it is at a maximum. Thus, no matter what the firm
does in production it can't increase profit. Profit is maximized. Consequently,
if you can show that profit is still rising then we know profit is not
a maximum. For profit to be maximized means profit can't get any higher.
Explain how profit can be increased by changing the amount of output
produced. Suppose you produced one more unit of output explain what will
happen to profit when MR>MC.
Remember profit is TR-TC. MR is adding to revenue and MC is adding to
cost. If you increase output when MR>MC what happens?
How can profit be increased when MC>MR?
You can see that the only time profit can't increase is when MR=MC.
Remember the market structure we are discussing is perfect competition.
In perfect competition we said P=MR thus when we talk about profit maximization
in a perfectly competitive market place we say profit is maximized when
MC=P. (P=MR). In every other market structure we must say profit is maximized
Look at table 9-3. If we were to produce 4 units of output notice MC =60 and MR = 131.
Would you as the owner of the firm produce this 4th unit
of output? Why or why not?
On the same table explain why you would or would not produce the 5th, 6th, 7th, 8th 9th or 10th units of output.
Notice profit is maximized (can't increase anymore) upon producing the 9th unit of output. MR=131 and MC = 130. Yes they are not exactly equal but what happens to profit if produce only 8 units of output and what happens if you produce 10 units of output.
Go back to your cost curves and draw the U shaped marginal cost curve.
We know MR=P and is horizontal so now draw that. Make sure the MR curve intersects the MC curve at some point where MC is rising. You will note that even though MR=MC when MC is falling we are never concerned about producing there because the firm will not build a short run plant if they only planned on producing that small amount of output. Remember when MC is falling MP is rising which implies to large a capacity for the level of output the firm is going to produce.
Draw your graph:
So on the graph make sure you can explain why profit will rise (if rising
not a maximum) when MR>MC and also explain why profit will rise if MR<MC
to the right of the point of intersection.
(Insert figure 9-3)
Notice how this picture shows that when MR =P profit is maximized at
9 units of output. The question we want to ask is whether or not the firm
is making an excess profit.
Is this firm (using figure 9-3) making an excess profit?
Explain why or why not and how you can tell.
The first question we ask is whether the price of $131 is great enough
to cover the average total cost of making the 9 units of output which allows
us to maximize profit.
What kind of profit is the firm already making when we look at ATC?
Thus we see the profit above a normal profit is called economic or excess
Now just jumping ahead of ourselves for a second. In perfect competition when we have excess profit what will happen? New firms will enter the market place to get some of this excess profit. Everyone sees how successful you are and conclude they want a piece of that excess profit.
When new firms enter the market what happens to the market supply curve and the market price? Draw the original supply and demand curve and have them intersect at a price of $131. Now draw the new supply curve for the market showing people entering the market due to the excess profit.
Notice the supply curve shifts to the right. The price is lowered.
Is there anything preventing people from entering the market? Why
or why not?
Now suppose when new firms enter the market place the price falls to $81.
(Insert figure 9-4)
Your costs have not changed at all but now the price you can charge has been reduced to $81.
Explain why you must charge the market price of $81.
Now lets ask ourselves the same questions.
What is the output level where is profit maximized? Explain why.
At profit maximization is the price ($81) the firm receives for each unit sold great enough to recover its total cost?
On table 9-4 what is the average total cost for the profit maximizing output?
Notice the $81 is not enough to recover ATC.
What should you do, stay in business or shut down? Explain.
Before you explain suppose you decide to shut down when 6 units of output is the profit maximizing level. What would your AFC be?
Note if you shut down you still have to pay the AFC thus you would loose this amount of money. Now suppose you stay in business and produce 6 units of output. How much money would you loose? ($91.67-81) or $10.67. Now if you shut down you loose $16.67 if you stay in business you loose $10.67. Which would you rather do? This is called the loss minimization case. While the price is not high enough to cover your ATC that is $81<$91.67. You will notice that the price of $81 is enough to cover the Average variable cost.
What is the average variable cost at 6 units of output?
Look at figure 9-4. Notice the loss is only a portion of the AFC. Remember AFC is the distance between ATC and AVC. If you shut down you loose all of the AFC. By staying in business and operating at a loss you only loose a portion of the AFC.
Why do you suppose you can stay in business in the situation when you do not recover all of your ATC?
Remember part of ATC is a normal profit and returns to the entrepreneur
When we looked at total cost we included implicit costs. Now part of
that was a normal profit. Suppose your normal profit was higher than you
would be willing to accept. Now as a result of the price declining you
will not draw a normal profit but you can still pay yourself a salary.
Your salary may be less than you hoped for but by staying in business you
hope to turn things around and get your normal profit back.
Now look at figure 9-5 and table 9-4. Notice if the price is $71 rather than $81.
This occurred because when new firms entered the market the supply increased
enough to drive the price down to $71. First determine where profit is
maximized. It is where P = MC. Notice no matter what level of output the
firm produces ATC and AVC cost is above the P. Thus at this point the firm
is not making enough on each unit sold (at a price of $71) to even pay
its variable costs (usually workers). Thus if you stay in business you
will loose more than your AFC. You will loose all of your AFC plus a portion
of your AVC. Thus it is cheaper for you to shut down and produce nothing
and only loose your AFC.
Now lets finally figure out how we get the supply curve.
(Insert figure 9-6)
Notice what happens when firms make excess profit. New firms enter the
market place to try and capture that excess profit. As new firms enter
and compete the price is lowered.
On that picture suppose the price was initially P5.
Profit is Maximized where P5 = MC at point e.
Why do we make an economic profit?
What happens when other people see this economic profit we are making?
Explain what happens to the market supply curve and the market price. Draw
the diagram for supply and demand.
Suppose the price falls to P4. The new equilibrium is now at point d.
Notice at this point the price received is equal to the minimum point of the ATC curve.
What do we know about the profits, to the firm, at this point?
This point is called the break even point.
Now suppose firms keep on entering the market and the price drops (as a result of supply increasing) to P3. The equilibrium point occurs at point c. Again the firm will stay in business rather than shut down.
Explain why the firm stays in business at point c?
Suppose the price falls to P2.
How much will the firm loose at this point if it stays in business?
How much will the firm loose at this point if it shuts down?
This is called the shut down point because for any price below P2 the firm will shut down.
Why will the firm shut down at a price of P1?
Remember that the supply curve shows the positive relationship between
price and quantity supplied. The higher the price the more a firm will
supply. On figure 9-6 when price is P5 the firm will supply Q5 units of
output to maximize profit. When price is P4 in order to maximize profit
the firm will supply Q4 units of output, when price is P3 the firm maximizes
profit when it supplies Q3 units of output and when the price is P2 it
supplies Q2 units of output. If price is less than P2 it shuts down and
supply is zero. Thus the marginal cost curve above the minimum average
variable cost curve is the supply curve because it shows the relationship
between quantity supplied and price.
This is just one supply curve for one firm in a perfectly competitive
industry. If we horizontally sum all of the individual firms supply curve
we will get the market supply curve. But remember the firms supply curve
is its Marginal cost curve, thus we sum all the marginal cost curves to
get the market supply curve.
Thus the market supply curve is positively sloped and the market demand curve is negatively sloped and when they intersect in the short run equilibrium price and quantity will occur.
Long Run Supply Curve
We will now show how we get the long run supply curve. We can't just say it is the marginal cost curve above the minimum AVC because now all the inputs are variable thus can't look at marginal cost the same as we did in the short run. Here is how we get the long run supply curve.
In the long run all the inputs of
the firm can change thus there are no fixed inputs. The plant size in the
long run can change. This could not happen in the short run. There are
long run cost curves which we discussed. But there is only a long run total
cost curve because there are no variable inputs thus no variable cost.
Profit is maximized where MC equals marginal revenue.
As we discussed this we must be aware of the assumptions we are making.
(Insert figure 9-8)
As we go through this picture you
may want to draw everything on your own. You will draw two pictures side
On one picture draw a supply and demand curve. Mark off the equilibrium quantity and price. Now next to that picture (just like in figure 9-8) draw the equilibrium cost curves. Notice the price established by intersection of demand and supply becomes the MR curve for the firm. Assume that the firm is making just a normal profit. Thus there are no reasons for new firms to enter. MR equal ATC at its minimum point which also is where MC=ATC. In figure 9-8 we are using D1 and S1 which established a price of $50. This is the long run equilibrium condition. There are no excess profits so no firms are entering and there are no losses so no firms are leaving. The long run equilibrium point is at the minimum ATC where ATC=MC=P=MR. Now suppose something happens and Demand increases to D2. It is possible that income increased, or consumer tastes increased for the good or the price of other goods increased etc. that is one of our ceteris paribus changed and the demand curve increased to D2. With this increase in demand equilibrium price rises to $60. (again the sixty dollars is just a number we use what is important is that prices rose.) Now with this higher price we see the new MR is now above the minimum average total cost curve.
What kind of profits is the firm
What will other firms do as a
result of this profit?
So now as a result of the excess profit new firms enter the market and supply increases to S2. So supply increases back to a position such that the original equilibrium price is restored. Thus when there is a profit in long run firms enter the market to remove that profit.
Insert Figure 9-9
Suppose demand declined instead of increasing. This forces the price and MR to fall. This causes profit to decline in the industry thus firms leave. When firms leave supply declines to S3 and price goes back up to recover ATC.
In both of these examples note that when the firm increased or decreased the two equilibrium points of the new supply and demand when connected formed a horizontal supply curve.
If you connect these two equilibrium points on the demand and supply curves that is the long run supply curve. Notice it is horizontal. In a constant cost industry the long run supply curve is horizontal. The reason is that when firms expand the prices of the resources they use in production does not change.
Why don’t input prices change when the industry expands?
Because we are in a perfectly competitive input market and this industry is just a small part of all of the industries that use the input. Thus if they increase demand for the inputs because they are expanding it has not effect because there demand is tiny compared to the total demand for that resource.
Shows the Long run supply for a constant cost industry.
Long run supply for an increasing cost industry.
An increasing cost industry means that when the industry expands it bids the price up for the inputs. This is a much more realistic model. Thus when the industry expands costs rise and the entire cost curve shifts up. In the unrealistic constant cost industry model the cost curves did not shift when the market expanded.
So to draw this start off exactly as before with the long run equilibrium condition.
So try to draw this. Remember pictures are side by side.
First draw the demand and supply curve. The price established there is MR. Now since in equilibrium the MR = ATC at its minimum point. Thus just a normal profit. Now again for some reason demand increased. Draw the new demand curve. Notice price rises thus now there is an excess profit. With this excess profit new firms enter the industry but this time they drive input prices up. But with this excess profit new firms enter and supply increases which put pressure on prices to fall again. But this time since input prices rise the cost curves shift up. Thus the new supply curve does not increase all the way to the old price and we see the new equilibrium price is a little higher. We connect these two equilibrium point and we see that we get a positively sloped long run supply curve.
See if you can show why the long run supply curve for a decreasing cost industry is negatively sloped. Go through the entire process except now when the industry expands input prices actually fall and the cost curves actually shift down.
Insert figure 9-12
Notice in this picture that although
a firm can make excess profit in the short run in the long run it can only
make a normal profit. This means that in the long run MR=MC=ATC=P. Thus
the firm is always producing in the long run at the minimum point on the
ATC curve. Thus this firm is producing its output at the least possible
cost. It is using the least amount of resources to produce its output.
(Remember if it was using more resources than it needed to produce at the
cheapest cost then the price would not be greater enough to recover its
costs and some firms would leave the industry.
When price equals the minimum point
of the ATC curve we say there is productive efficiency.
If the firm does not produce at the least cost it will loose customers to other firms in the industry. So in a competitive market the consumer benefits from this because the cost and price will always be at the minimum total cost. They will always be able to pay the lowest price for the goods.
So Productive efficiency occurs
when P=Minimum ATC
Allocative Efficiency also occurs.
Remember productive efficiency means that the goods are being produced
the cheapest way possible and we see this occurs when P= minimum ATC. But
allocative efficiency means that the right mix of goods and services are
being produced that are most wanted by society (consumers). I.e allocative
efficiency tells us that the goods consumers want the most are being produced.
We will show that this also occurs.
Go back to the beginning of the
semester when we talked about marginal benefit MB and marginal cost MC.
The price that the market establishes
is the MB to society. That is the price of the product tells us the relative
worth to society of that product. It tells us the MB of the product.
MC really tells us the opportunity
cost of the good we are producing. Because alternative uses of the resources
could be made with those costs of producing the good we are talking about.
MC is telling us how much society is willing to give up in order to get
a unit of the good we are talking about.
Now when P=MC allocative efficiency will occur.
When P > MC explain why this is not allocative efficient.
Profit is maximized when P=MC. Thus
if P>MC profit can be increased by producing more of the output. But if
the firm is actually at a point where P > MC then that means it is not
maximizing profit and the firm is under allocating resources toward the
production of that good. Thus less of that good will be produced, and fewer
people will be able to obtain that good. Thus resources are being used
instead to produce other goods that people do not want as much as this
Remember P>MC means that MB>MC.
Utility of society could be raised by producing more output (because MB>MC)
but since it does not produce the output that gives more utility society
is receiving less utility than it would if output was increased. Thus there
is a under allocation of resources toward the goods that consumers want.
On the other hand if P<MC that means production is more than what society wants. Remember P<MC means that MB<MC and by producing less total benefit can rise. Thus the firm will produce to much and over allocate resources to that good.
Thus allocative efficiency occurs
when P=MC which occurs at the minimum point of the ATC in the long run.
This model is useful because we see what happens when demand for a product should change. If demand increases prices rise and now P>MC and efficiency will occur because excess profits due to the higher price will cause firms to enter the industry and increase supply which will bring us back to equilibrium in the long run.